The Schwab Center for Financial Research evaluated the long-term impact of taxes and other expenses on investment returns, and while investment selection and asset allocation are the most important factors that affect returns, the study found that minimizing taxes also has a significant effect.1
There are two reasons for this. One is that you lose the money you pay in taxes. The other is that you lose the growth that money could have generated if it were still invested. Your after-tax returns matter more than your pre-tax returns. It’s those after-tax dollars, after all, that you’ll be spending now and in retirement. If you want to maximize your returns and keep more of your money, tax-efficient investing is a must.
Most investors know that if you sell an investment, you might owe taxes on any gains. But you could also be on the hook if your investment distributes its earnings as capital gains or dividends; whether you sell the investment or not.
By nature, some investments are more tax-efficient than others. Among stock funds, for example, tax-managed funds and exchange traded funds (ETFs) tend to be more tax-efficient because they trigger fewer capital gains. Actively managed funds, on the other hand, tend to buy and sell securities more often, so they have the potential to generate more capital gains distributions (and more taxes for you).
Bonds are another example. Municipal bonds are very tax-efficient because the interest income isn’t taxable at the federal level—and it’s often tax-exempt at the state and local level, too (munis are sometimes called « triple free » because of this). These bonds are good candidates for taxable accounts because they’re already tax efficient.
Treasury bonds and Series I bonds (savings bonds) are also tax-efficient because they’re exempt from state and local income taxes. But corporate bonds don’t have any tax-free provisions, and, as such, are better off in tax-advantaged accounts.